Concrete Thoughts: Inflation Valuation

One of the questions on many minds today is whether inflation will hit in a meaningful way and, if so, what the impact will be on commercial real estate. If we do experience above-trend inflation, the impact on our real estate market will be significant.

Inflationary pressures have been relatively controlled recently as headline inflation (as opposed to core inflation, which excludes food and energy prices) has been below the upper end of the Federal Reserve’s comfort zone of 1 to 2 percent. During this recession, we have experienced massive asset price deflation as we have seen dramatic reductions in value.

Overall, consumer-goods pricing has been fairly stable primarily because the velocity of money has dramatically decreased. Within a recent nine-month period, the Fed committed to a doubling of the U.S. money supply, an increase greater than the aggregate increases in our nation’s money supply over the past 50 years. As a result, inflation has remained steady despite significant asset price deflation. Absent this massive monetary expansion, we would have witnessed an enormous deflation, due to the decline in velocity as Americans held on to their quarters so tightly you could hear the eagles screaming.

Capricious and irrational government policy under both the Bush and Obama administrations created tremendous uncertainty, resulting in massive fear in the hearts of people. This resulted in cash being the only safe haven for investment dollars.

Americans liquidated investments in stocks, bonds and hedge funds and put their cash in banks (several different banks, even after the F.D.I.C. insurance threshold was increased from $100,000 to $250,000), money market accounts, Treasuries and even under the mattress as the soundness of our financial system was in question. This dynamic became so pronounced that, at one point, Treasuries were paying negative interest rates. This was reminiscent of the 1800s, when citizens paid the local bank to hold their gold in the bank’s vault.

Asset values were crushed by the flight to cash in the face of arbitrary government decision making. It drove investors out of the market, causing excess volatility and abnormal levels of illiquidity.

THE DOW IS ONCE again approaching the 10,000 threshold. Over the last two earnings periods, corporate profits have exceeded expectations, driving the equities markets higher. However, these profits were achieved with significantly lower revenues. As revenues fall, the only way to achieve profitability is by increasing productivity and slashing overhead. American companies have responded by greatly reducing labor costs, and workers (those who still have jobs) have become more efficient, as productivity has increased by about 6 percent.